The end of monetary policy?

As global quantitative easing (QE) increases and interest rates outside the US continue to be cut, Insight Investment’s inflation-linked corporate bond manager, David Hooker, assesses the practicality of monetary policy in the coming year.

Some monetary authorities and commentators alike have begun to question whether the current policy regime can solve the world’s economic problems. With confidence in the effectiveness of monetary policy in decline, 2017 could be a year where the debate about the future of monetary policy moves into the political mainstream.

Central banks went into the aftermath of the global financial crisis with the belief that monetary policy could be the panacea for the global economy’s ills. By cutting interest rates, central banks have attempted to influence the overall level of activity in the economy by lowering the cost of borrowing for consumers and businesses in order to encourage them to spend more and save less. Once key policy rates approached or reached zero, cutting interest rates further was (initially) deemed to be unpalatable.

Central banks turned to unconventional policies such as asset purchase programmes to loosen policy further. The hope was that by boosting asset prices this would encourage increased spending through the creation of a positive wealth effect for asset holders. Some central banks have since resorted to negative interest rate policies as doubts over the effectiveness of traditional policy measures grew.

Asset purchases and credit easing coupled with cuts in interest rates are the current instruments of choice for central banks. In August 2016, the Bank of England (BoE) demonstrated this when it launched an aggressive package of monetary measures to counter the potential economic impact of the UK’s June decision to leave the European Union including; a cut in interest rates, asset purchase programmes in government and corporate bond markets and credit easing through the Term Funding Scheme.

Time will tell what impact the measures taken by the BoE will have. However, some have begun to question the effectiveness of monetary policy given that growth in major economies remains lacklustre at a time when interest rates and bond yields are low (the so-called Keynesian liquidity trap), leading to calls for an entirely new policy framework to be explored.

Even as the BoE was introducing its package of measures, other monetary authorities had begun to question the effectiveness of the current monetary policy regime. The US Federal Reserve noted that both monetary and fiscal policy appeared better positioned to offset large positive shocks than adverse ones. The Bank of Japan (BoJ) carried out a comprehensive review of its current policy measures as it attempted to demonstrate its commitment to end deflation. Following its review, the BoJ shifted the focus of its monetary stimulus in September from expanding the money supply to controlling interest rates, a move deemed by some economists as further evidence that BoJ policy had reached the limits of its effectiveness.

The sustained rise in worldwide debt is further choking global growth. As interest rates have pushed lower, although debt servicing costs have been reduced, absolute debt burdens have pushed higher as the economic response has underwhelmed. It is argued that this mounting private sector debt burden has served to undermine economic growth and that an active fiscal policy could be a more effective policy tool to help tackle it.

In the UK, for example, commentators question if ebbing confidence in the outlook for the UK economy, borne from a lack of clarity regarding the future economic relationship between the UK and its major trading bloc, can be bolstered by monetary policy alone. A targeted fiscal response aimed at boosting investment would have perhaps been a better response given the specific shock the UK faced. However, critics of fiscal policy would point to Japan to highlight the limitations a reliance on debt funded infrastructure spending and stimulus packages has on growth in the medium and longer term.

The distributional impact of monetary policy has also begun to attract attention. It is generally perceived that asset purchase programmes have benefited those who own assets compared to those without and these tend to be held by the wealthy. Policies that were initially described as “emergency policies”, are increasingly being criticised by the “losers” of the distribution effect as the economic benefits of these policies are becoming less visible or even counterproductive.

Central banks generally dismiss this, claiming all monetary policy actions have distributional consequences and they are technocrats doing a job mandated to them by governments. It is governments that should act to correct this, they say.

It is hard to argue that independent central banking is not political. Central banks need the support of the population to exist. With emergency measures enduring for close to a decade, confidence in monetary authorities has understandably diminished.

Populist effect

Economic unhappiness often leads to the rise of populist parties or populist policies. Populist momentum can be a very powerful catalyst for reform. Initially they are often seen through promises of extra government spending, usually on infrastructure projects to stimulate economic growth and social initiatives to combat inequality. Established political parties are good at taking the policies of populist parties and implementing them so it does not necessarily result in the demise of the current political incumbents. But the independence central banks enjoy is a gift of politicians. To ensure political survival it may be deemed necessary for governments to change the framework of monetary policy. What eventually replaces the current global policy framework and over what time scale is open to debate.

However, while the outlook for the global economy remains uncertain, the dominance of monetary policy and independence of central banks is likely to wane. This debate could move from academic circles into the political mainstream through 2017, but it is probably not until the next economic crisis hitsthat we are we likely to see the rise of the new monetary order. This could have significant implications for inflation and the independence of central banks.

What to watch in 2017

A possible further decline of confidence in the effectiveness of monetary policy.

Could the debate about the future of monetary policy move into the political mainstream?